Should you consider trying one of the dozens of absolute return funds on the market? Yes, says Gabriel Burstein, global head of investment research for Lipper and Digital Ventures. “The funds offer ways to control risks,” he says. Lipper tracks three classes of absolute return funds, portfolios with low, medium, and high risk. During the three years ending in December 2010, all three groups delivered competitive returns. But low-risk funds did the best, staying in the black and beating global equity and long-short funds, which lost money.

Lipper defines absolute return funds as portfolios that aim to outdo T-bills or another benchmark by a fixed amount—regardless of how stocks or bonds perform. The funds use a variety of different strategies. Some hold long and short stock positions, while others use options and convertible arbitrage. “Absolute return funds can have a great advantage because they can switch strategies as markets change,” says Burstein.

Not everyone shares the enthusiasm for the funds. Fund tracker Morningstar decided not to establish an absolute return category. It is difficult to determine what funds might belong in the group, says Morningstar analyst Nadia Papagiannis. “These funds are all over the map,” she says. “They don’t follow a particular strategy.”

While the absolute return funds have short track records, many have failed their first tests, says Papagiannis. Most funds suffered losses in 2008, a year when investors especially needed protection. Some funds have shown high correlations with stocks, she says.

Still, a few of the absolute return funds have posted intriguing results, delivering positive returns while remaining less volatile than the stock markets. To diversify portfolios, consider PIMCO All Asset (PASAX). The fund aims to outdo the consumer price index by 5 percentage points annually. Lately, the PIMCO fund has fallen short of the target, but shareholders are not likely to complain. During the five years through November, the fund returned 5.7 percent annually, outdoing 97 percent of competitors in Morningstar’s moderate allocation category.

Instead of buying individual stocks or bonds, portfolio manager Robert Arnott invests in a range of PIMCO funds. Worried that markets were becoming expensive early in 2008, he cut exposure to stock funds, limiting losses in the downturn. Then he began buying depressed high-yield bonds, riding them to gains in 2009. Worried about the threat of inflation, Arnott now owns PIMCO Real Return Asset (PRAIX) and PIMCO Commodity Real Return (PCRRX).

Another promising choice is Quaker Akros Absolute Strategies (AARFX), which has returned 2.7 percent annually for the past five years, outdoing 60 percent of funds in Morningstar’s long-short category. Portfolio manager Brady Lipp develops a top-down outlook for the markets. When stocks look rich, he can shift the fund to a position that is up to 6 percent net short the market. When shares look cheap, he can go 100 percent net long. Early in 2009, he had a big long stake, but these days the fund is in a market-neutral position, holding roughly equal amounts of long and short positions. “The market is overvalued,” says Lipp. “There are tremendous risks in the economy.”

Besides stocks, the fund can also hold options, convertibles, and preferred shares. Lipp only buys stocks that sell for less than 70 percent of their fair value. A favorite holding is Microsoft. He says that the stock sells for about 10 times forward earnings. But the company is growing nicely and increasing its dominant position.

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